In its quarterly inflation report, the bank forecast thatthe world's sixth-largest economy would expand just 1.6 percentthis year, down sharply from its previous estimate of 2.5percent, but in line with most market estimates.

The revision highlights President Dilma Rousseff's biggestchallenge - restoring Brazil's economy to the glory days of thepast decade, when annual growth rates above 4 percent helpedlift millions out of poverty and make the South American countrya star among emerging markets.

The Rousseff administration has prevented an even deeperslowdown by taking stimulus measures that include tax breaks fortargeted industries and a year-long rate-cutting campaign thathas brought borrowing costs to an all-time low.

But the easing cycle now looks to be over after the centralbank raised its inflation forecast for this year to 5.2 percentfrom 4.7 percent.

Additional rate cuts could nudge inflation closer to the 6.5percent ceiling of the government's target range, a result thatwould provide additional fodder for critics who worry thecentral bank has pushed inflation targeting to the back burnerwhile it focuses instead on economic growth.

Brazil's economy has been stagnant for much of the pastyear, hit by fallout from the European debt crisis, slowergrowth by k ey tradin g p artner China and homegrown problems su chas a manufacturing sector struggling wit h hi gh taxes and ast ro ng local currency.

Fortunately for the central bank, government plans to reduceelectricity rates should help ease inflation pressures in 2013,a year when economic growth could rise back above 4 percent,according to many economists. As a result, the central banklowered its inflation forecast for next year to 4.9 percent from5 percent.

Still, both inflation estimates remain well above the centerof the official target range of 4.5 percent - plus or minus 2percentage points.

"The bottom line is that the central bank recognizes thatits policy is not helping inflation converge toward the centerof the official target and that makes it more likely that the(benchmark) Selic will remain where it is now," said MauricioRosal, economist with Raymond James in SÃ£o Paulo.

While analysts expect the central bank to leave the Selicrate unchanged at 7.5 percent at its next meeting on Oct. 10,investors are somewhat more cautious.

Trading in Brazilian interest rate futures onThursday implied a 50 percent probability that the bank willleave rates unchanged at the bank's next meeting, according toThomson Reuters calculations. The other half isbetting on a cut of 25 basis points.

Central bank director Carlos Hamilton Araujo, a votingmember of the monetary policy committee, added to some analysts'perceptions that the bank is done cutting rates for now.

"The room to continue lowering rates has been reduced,"Hamilton told reporters in Brasilia after the release of theinflation report. He added that any immediate efforts to bringinflation back to the center of the target this year would have"high costs" in terms of activity.

CAUTIOUS TONE

In the report, the central bank acknowledged that the pathof 12-month inflation toward the center of the target was notlinear. In other words, there would be ups and downs before theconsumer price index settles around 4.5 percent.

For more than two months, the annual inflation rate has moved upward. A rise in food prices pushed inflation up to 5.24percent in August, reversing a downward trend that tookinflation to a near two-year low of 4.92 percent in June.

While the outlook for next year is better, doubts remainwhether Brazil's economy can regain the momentum of years past.

Fitch Ratings, which cut its estimate for Brazil's 2012growth to 1.5 percent, expects the economy to grow 4.2 percentnext year. However, it said its 2013 forecast is uncertain,"given the international financial volatility and the pace atwhich the Brazilian economy responds to monetary and fiscalstimuli."

The central bank did not provide economic growth estimatesfor 2013 in its quarterly inflation report.